In today’s macro environment fraught with confusing cross-currents, real estate has continued to show investors its flexibility and mettle. In particular, mezzanine debt, global real estate investment trusts (REITs) and build-to-core strategies hold great potential.
It’s easy to see why. Real estate can help investors fill any number of roles that span the risk spectrum. Historically, prime commercial real estate (also known as core) has been a favoured asset class with institutional investors, especially insurance companies and pension funds, which appreciated its long-term liability-matching attributes. It has been heralded as a potential hedge against inflation, and it’s clear that real estate can fill a bucket at either end of the risk spectrum. But perhaps the most compelling reason for real estate in the current environment is its ability to offer investors secure and attractive income at a time when there’s a dearth of such risk-averse assets.
Yet, despite real estate’s potential benefit and multiple uses in a portfolio, on a global basis, many institutions remain under-allocated to the asset class. One reason for this might be that investor attitudes continue to be coloured by the worldwide financial crisis. “On the whole, investors are still exhibiting cautious attitudes,” agrees Jack Chandler, head of BlackRock’s global real estate business. “Market volatility and declining funded ratios steered many toward the relative safety of fixed income assets. And within the real estate asset class, investors have demonstrated risk aversion by focusing most of their attention on the top-tier core properties that they deem the safest.”
Being both risk-averse and yield-hungry is a tricky combination, to be certain. Fortunately, there are ways for institutions to address this conundrum by looking beyond the narrow realm of equity investments in core real estate assets. Investors should weigh the merits of other strategies and approaches as they continue to fill out their real estate allocations.
Mezzanine debt
Opportunities in mezzanine debt—that layer of financing sandwiched between senior debt and common equity—may be among the most appealing commercial real estate opportunities in the current low-yield environment.
“Speaking in the broadest terms, current yields on real estate debt typically range from 7% to 15%, depending on the position within the capital stack and the dynamics surrounding the underlying collateral,” explains Robert Karnes, portfolio manager responsible for BlackRock’s global high-yield real estate debt investments. “But what’s especially appealing about mezzanine debt is the risk-adjusted nature of the returns. The yields that investors can capture look particularly favourable relative to other Canadian fixed income products.”
Upside potential aside, mezzanine debt is really about generating steady income.
Mezzanine capital offers investors some of the appealing characteristics of both debt and equity investments. On one hand, mezzanine debt is cushioned from the first loss position of real estate equity, yet, on the other, the debt investor can still be in a position to participate in upside appreciation depending on the structure of the transaction. Upside potential aside, mezzanine debt is really about generating steady income.
One reason this strategy is so exciting right now is both the size and the relative quality of the opportunity. Investors need income. Borrowers need capital. It’s a perfect marriage. A report by Deutsche Bank estimates that US$900 billion of commercial real estate loans are set to mature in the U.S. over the next two years alone, and another US$538 million of loans are maturing in Europe through to the end of 2013.
Many borrowers on the hook for these maturing loans will have trouble refinancing for the full amounts, given that they were funded in a very different economic regime when underwriting criteria and loan-to-value ratios were much more lax than today.
Clearly, the demand for commercial real estate financing is ample. At the same time, traditional sources of real estate debt, especially banks, have a diminished appetite for lending and are shrinking their balance sheets. Compounding matters is the fact that the securitized debt market is significantly less robust than pre-global financial crisis days.
“Who will step in to fill this lending void?” asks Floris Van Dijkum, head of real estate research and strategy with BlackRock. “The supply and demand fundamentals are very favourable, and we believe this offers a meaningful risk premium that reflects the limited supply of capital as opposed to the underlying property risk. It’s a great time to be a lender.”
Of course, mezzanine debt is not without its risks. Investors need the ability to gauge both economic and local market conditions in underwriting deals. Property fundamentals still matter in risk management, and investors need to be able to dig into the operating details on a deal-by-deal basis. The market is relatively opaque and not terribly efficient in terms of information and capital flow. And deals must be negotiated and structured with care since there is counterparty risk associated with enforcing loan covenants. “A nimble manager can expose the inefficiencies and deploy capital at ideal parts of the capital stack,” suggests Van Dijkum. “And, depending on investor preferences, a mezzanine debt strategy can be tilted from the more risk-averse-targeting yields in the high single digits all the way to the opportunistic end-of-the-spectrum-seeking returns in the mid-to-high teens.”
Global REITs
For quick and effective deployment of real estate capital, investors might consider looking at listed REITs and quoted property companies. This approach may help investors overcome the liquidity and logistics inherent in direct property investing.
“Global REITs offer investors an excellent way to further diversify within a broader real estate strategy, especially given the strong performance of the Canadian real estate market in recent years,” says Steven Cornet, a member of BlackRock’s real estate equity group. “The REIT structure continues to gain favour in Europe and Asia, and institutions have ample choices with regard to property type, markets and even strategies. It’s getting easier to fine-tune risk and income preferences through a portfolio of actively managed REITs.”
Yield-hungry Canadian investors are gravitating to real estate opportunities, but they will still need to be patient.
In Canada, real estate offerings—most in the form of REIT units or common shares—raised nearly C$4 billion to mid-year, representing nearly 17% of all equity capital raised by July 2012, according to an August Financial Post article. Yield-hungry Canadian investors are gravitating to real estate opportunities, but they will still need to be patient—and willing to tolerate the inevitable periods when Canadian REITs fall out of favour and trade below underlying net asset values, sometimes for prolonged periods. And, not all strategies are available through listed markets—although this, too, is changing as REIT structures gain popularity and have debuted in many European and Asian markets.
Although REITs offer investors a chance to tap alternative sources of income, any discussion of them would be remiss without mentioning that they are also a natural fit for the beta end of the spectrum. Numerous exchange-traded funds and indexing vehicles can help investors deploy capital quickly—and with low-cost efficiency.
Build-to-core strategies
In an environment skewed toward risk aversion, institutional investors have been piling into core real estate assets since the financial crisis. While the liquidity crunch and general chaos in the financial markets punished prime property valuations in late 2008 and early 2009, the rebound was sharp. As a result, the opportunity to acquire such assets at reasonable discounts was fleeting. Office properties in prime submarkets—London’s West End and midtown Manhattan are just two examples—have returned to their pre-crisis levels. High street retail and well-leased multi-family properties benefiting from favourable demographics are also generating a great deal of interest and multiple bids. “Cap rate compression for core assets partly reflects the expected growth in net operating income, as well as the availability of financing,” Van Dijkum explains. “As a result, investors have been willing to accept yields as low as 5% to 6%. But at current valuations, some investors are exploring other ways to get their hands on these attractive assets.”
For larger investors with separate account mandates, a more eclectic build-to-core strategy may be appropriate. The concept is simple enough in theory: acquire land or a well-located but flawed asset and develop, improve or otherwise re-tenant it to create a Class A asset that has the ability to kick off strong, steady cash flow over the long term. In reality, the investor needs to have access to research and a much broader set of capabilities to deliver on such a strategy. Although challenging, this should not be ruled out, especially if the intent is to build a portfolio of long-term income-generating assets.
BlackRock recently helped an institutional client execute just such a strategy, with the acquisition of 17 parcels totalling 2.7 acres and approximately 52,200 square feet of buildings in Hollywood, Calif. The acquisition was driven by a research view that Hollywood was a coveted residential submarket within the Los Angeles metropolitan area, where demand growth was favourable and vacancy and rental rate metrics were providing a strong tailwind. The strategy entailed selling off the existing tenanted buildings to reduce the land basis, while securing entitlements to construct 214 units of a Class A apartment, along with more than 13,000 square feet of ground floor retail and a 260-space parking garage. That’s no small task, and, as with any development, it’s not necessarily for the timid. But for larger institutional investors with a longer-term vision for growing a portfolio of high-quality core assets, this remains a viable option worth considering.
For risk-averse and yield-hungry institutional investors, mezzanine debt, global REITs and build-to-core strategies are worth a look.
Eric Léveillé is a managing director with BlackRock Canada. eric.leveille@blackrock.com